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Will the economy save Trump?

WASHINGTON -- For President Trump, a lot is riding on the economy in 2018. If it continues to do well, it should bolster his popularity and his claim that he understands it better than his critics. But if it slows or drops into a recession, it would weaken that claim -- perhaps his strongest selling point.

So, what's the economic prognosis?

First, the usual caveat: Presidents have only limited influence over the business cycle, which is heavily driven by outside events, past policies and the Federal Reserve. No matter. People still tend to credit or blame the sitting president for the economy's performance.

For Trump, that's fabulous news. The economy is thriving, and most mainstream analysts believe it will stay that way through the year. An improving global economy compounds the effect.

Consider the forecast from IHS Markit, a consulting firm. It expects U.S. economic growth of 2.6 percent in 2018, better than the 2.3 percent in 2017 and much better than the 1.5 percent in 2016. The unemployment rate, now 4.1 percent, will drop below 4 percent. But inflation won't worsen. For 2018, consumer prices are expected to increase 1.3 percent, down from 2017's 2.1 percent.

All this recalls the "Goldilocks economy" of the late 1990s, when growth was fast enough to create jobs but not so fast as to stoke sharply higher inflation. More jobs, rising home prices and a surging stock market are boosting "consumer spending, [business] capital expenditures, and housing," Nariman Behravesh, IHS Markit's chief economist, told clients.

Who gets credit? Democrats can argue that 90 percent of the 17.6 million new jobs since the Great Recession's low point occurred during Barack Obama's presidency. Trump supporters can retort that the galloping stock market reflects confidence that his pro-business policies will raise economic growth.

The more interesting question is whether events might derail the standard 2018 forecast. There are many possible threats: higher interest rates from the Fed; a financial crisis in China; war on the Korean Peninsula; a surprise leap in inflation. But the clearest danger comes from sky-high stock prices.

From the 2016 election to the end of 2017, stocks rose 26 percent, propelled by advances in tech stocks, according to Wilshire Associates. That's a paper gain of $6.7 trillion. By many standard measures, the resulting prices of U.S. stocks are high. The market's P/E ratio (stock prices compared to their earnings -- that is, their profits) is about 24 for the Standard & Poor's 500 stocks compared with a historical average of 17 since 1936, reports Howard Silverblatt of S&P.

"Stock prices are a source of recession risk," argue economists Gail Fosler and Edward Logan of the GailFosler Group.

Simplified a bit, their theory goes as follows.

There's income and there's wealth. Income is what people earn from their jobs and their investments; wealth is what they own -- mainly homes and stocks. For many years, changes in incomes and wealth moved together. Now, wealth movements have acquired a life of their own, so that shifts in wealth shape the business cycle. When people feel richer, they spend more. When they feel poorer, they spend less.

What's happening, they argue, is that stock prices have outraced income gains. When the resulting "bubble" bursts, paper wealth will be destroyed, spending will slow, and there will be a recession. They think one will occur in 2018, probably in the second half of the year.

Some economists are more pessimistic. They believe that the overvaluation of stocks is global, reflecting widespread easy-money policies of government central banks.

"While in 2008 bubbles were largely confined to the American housing and credit markets, they are now to be found in almost every corner of the world economy," writes economist Desmond Lachman of the American Enterprise Institute in The New York Times. Lachman says he feels fairly confident that stocks will retreat -- but not when.

What's striking about the current situation is the huge disconnect between what's happening in the economy and what's happening in politics. Politics is unstable and chaotic. Polarization has intensified, and Trump has corrupted political debate with his constant, often-untrue tweets. Meanwhile, economic confidence is strong, and the stock market acts as if it has not a worry in the world.

To some extent, the contradictions can be reconciled by Trump's pro-business tax and regulatory policies. But the gap is too wide for this to be a fully adequate explanation.

Someday, the gap may be erased. But how? Will political chaos spoil the economy, or will economic confidence stabilize politics?